Japan changes tax treatment of D&O liability insurance premiums

Global Tax News

Japan’s National Tax Agency (NTA) has announced a new tax treatment of premiums for directors' and officers' liability insurance.

Typically, such premiums have been recognized in Japan as salary income. Under the new tax treatment, a company will not need to treat the amount of the insurance premium that covers shareholder derivative actions as a director’s salary income, provided that the company bears the cost of the premium, pursuant to corporate approvals such as resolutions by a board of directors.

Directors, accounting advisors, statutory auditors, officers, and accounting auditors (collectively, directors) owe the duty of care to their company, and directors and officers also owe the duty of loyalty under Japan’s Companies Act. Directors are liable to their company and third parties for damages as a result of their own actions that involve fraud or negligence. To cover this liability, in recent years D&O insurance has become common in Japan. It is reported that about 90 percent of listed companies were enrolled in D&O insurance as of March 2015.[1]

A conflict of interest may arise, however, if a company bears the cost of D&O insurance premiums in cases where the directors are sued for damages in a shareholder derivative action, and it would impair the functions of a shareholder derivative lawsuit (i.e., coverage of the company's damage and repression of illegal activity) if a company bears that cost. As a consequence, it has been common practice among insurance companies providing D&O insurance to exclude shareholder derivative actions from the general agreement and execute a separate agreement under which the directors themselves pay the premium for coverage of such actions. The premium for shareholder derivative actions has been historically treated as a fringe benefit and taxed as directors’ salary income, if the company bears the cost of such premium.[2].

In recent years, corporate governance has been an active topic of discussion in Japan. Various reforms have been made, among them amendments to the Companies Act which took effect in May 2015. These discussions of corporate governance also reflect a greater acceptance that companies need to appoint external directors. Many have noted two factors, however: first, the practice of treating D&O insurance for shareholder derivative actions as salary has had a negative effect, deterring director-level candidates from accepting office; and second, as a consequence, this practice has acted as a brake on the movement to enhance corporate governance.

Addressing these concerns, in July 2015, the Ministry of Economy, Trade and Industry (METI)’s Corporate Governance System Study Group published a report noting that payment of the D&O insurance premium for shareholder derivative actions by a company should be allowed if certain conditions are fulfilled:[3], [4]

a) approval by board of directors has been obtained and

b) consent by (i) a discretional committee made up of a majority of external directors; or (ii) all external directors has been obtained.

In response to this report, in February 2016 the NTA stated that it will not treat such insurance premiums as directors’ salary income, if the above two conditions are fulfilled.

To learn more about this development and its meaning for your company, please contact the authors.